The 2008 crisis and the role of exchange rates and trade flows

The 2008 crash wasn't simply a financial crisis. We must also look at the wider economics imbalances which had built up and which directly contributed to the unstable state of the world's finances.

Most
people believe that the economic crisis which peaked in 2008 was caused by
deficiencies in the banking and financial system and that reforms to stop
another similar crisis occurring should therefore concentrate on changing the
ways in which banks and the financial sector operate. There is no doubt that there
was an unsustainable boom in the 2000s across most of the western world,
feeding on very loose credit conditions and asset inflation, and that huge
increases in bank lending, some of it involving very dubious financial
engineering, contributed very substantially to the financial disaster which
subsequently materialised. The issue raised in this Bulletin, however, is
whether it was faults in the financial system which were the fundamental cause
of what went wrong or whether there were deeper reasons for the debacle which
meant that the financial system was the conduit rather than the causa causans for the huge loss of
output and the social distress which the crisis brought in train.

The
starting point for an alternative view about the events which peaked in 2008 is
to look at trading patterns over the preceding two or three decades. Here is
what happened:

In
the 1970s the Keynesian approach to economic management broke down, to be
replaced by monetarism. The result was a huge increase in interest rates and
tightening of the money supply across most of the West, which generated very
large increases in exchange rates. In the UK, for example, the real effective
parity of sterling rose by more than 60% between 1977 and 1981.

At
the beginning of the 1980s, by contrast, China began to engineer an enormous reduction
in the external value of its currency, the renmimbi. According to IMF figures,
between 1980 and 1985, the renmimbi was devalued by 37%. This, however, was
only the start. Between 1985 and 1993, a further devaluation of over 60% in its
real effective exchange rate took place, leaving the cost base for
manufacturing in China massively lower than in the West.

As
a result of the Asian crisis in 1997, many other Pacific Rim countries also
devalued their currencies by very large amounts, the Korean won, for example,
by about 50% and the Malaysian ringgit by 35%.

The
result for the West was that large swathes of manufacturing became uneconomical
as production migrated on a huge scale to the Pacific Rim. In the UK, for
example manufacturing as a percentage of GDP fell from 32% in 1970 to barely
10% now.

As
a high proportion of foreign trade is in manufactures rather than in services
or raw materials – typically about 50% - the inevitable result was that the
East began to pile up enormous balance of payments surpluses while the West
went into deficit. The UK has not had a balance of payments surplus in manufactures
since 1982 or an overall surplus since 1983.

It
took a few years for the scale of China’s increase in manufacturing output to
develop its full impact, but by 2008 China’s trade surplus in manufactured
goods peaked at $421bn, with its average surplus across all of its current
account transactions in the mid-2000s averaging about $250bn per annum. These
huge sums had to be mirrored by capital exports, much of which took the form of
China buying western government bonds, particularly US Treasuries as well as a
range of other assets.

In
the West, the effect of their massive balance of payments deficits with the
East was to suck demand out of western economies, which the authorities somehow
or other had to replace. This was done in two main ways, these being:

A Governments ran deficits to keep up demand,
partly because they had little alternative but to do so. This is because
government and balance of payments deficits are to a large extent mirror images
of each other.

Increasingly lax monetary policies were
introduced, encouraging asset inflation, particularly in housing and stocks and
shares, which encouraged consumers to keep spending. At the same time, credit
conditions were relaxed, encouraging consumers to spend more than they were
earning, thus enabling them to maintain or increase their living standards,
supported by increasing debt.

Given that, at the time, as
now, no western government had an explicit exchange rate policy which might
have tackled the root cause of trade imbalances which was the fundamental
reason for the problems they faced, there was little policy alternative to what
was done.

At the same time the enormous influx of
funds from the East, which was used to buy up assets in the West, kept western
exchange rate far too high while the export of capital funds from the East kept
their exchange rates far too low for most western manufacturers to be able to
compete against their industries.

The result was that conditions were
created where a major boom, driven by excessive credit creation was virtually
inevitable. It is the continuation of the same imbalances which has been
largely responsible for the slow recovery which we have seen in the West from
the crisis which materialised at the end of the 2000s.

If this analysis is correct
it has a substantial bearing on both what now needs to be done to get western
economies growing again at reasonable speed on a sustainable basis and what is
required to avoid an extremely damaging repetition of what occurred between
2007 and 2009. In particular we should consider:

If the
root cause of the 2008 crisis and the West’s slow growth especially recently is
trade imbalances caused by exchange rates which leave some economies with far
lower cost bases than others, then the most important objective should be to
tackle this problem. If the fundamental reason for the 2008 crash was excessive
trade surpluses and deficits rather than serious defects in the world’s
financial structure, then it is the trade problems which need to receive the
main focus of attention rather than financial reform.

Broadly
speaking, the target should be to achieve exchange rate adjustments which would
enable all the world’s diversified economies to have a sufficient share of
manufacturing – whose exports still make up such a high percentage of world
trade - to be able to pay their way in
the world, to avoid excessive and highly destabilising surpluses building up.

It would
be rational for all countries to participate in the parity adjustments which
would be required, to produce a much more stable world economy capable of
reasonably fast and sustainable growth. It is in fact no more in the interest
of surplus countries to curtail their living standards so that they can lend
vast sums to deficit countries which are never going to get repaid, than it is
for deficit countries to maintain exchange rates which ensure that they are
permanently constrained by balance of payments problems.

If much
more balanced trade conditions were in place it would make it much easier for
the financial system to be operated and controlled so that it ran on a stable
basis. Deficit countries would no longer be forced into creating excessive both
public and private debt to sustain demand. Governments could easily run
deficits – if they needed to do so at all – which were small enough to be
easily sustainable. The financial conditions leading to boom and bust would be
much easier to avoid.

In
particular, the two main thrusts of current financial reform would become much
less pressing. These essentially fall into two categories. One is to insist on
banks having much larger capital reserves in relation to their lending. The
second is to increase very substantially the extent to which banks and other
financial institutions are regulated.

The
problem with both these approaches is that each of them adds significantly to
the cost of finance while at the same time discouraging lending, making funding
harder to obtain particularly by the sectors of the economy – manufacturing,
exporting and import saving – which it is most in the interest of western
economies to encourage. It is not possible for banks both to deleverage and to
increase lending at the same time without massive increases in the capital they
have available to absorb losses. This is not an argument for doing nothing to
reform the financial sector but it does make a strong case for not trying to
put all the weight of economic reform on finance rather than trading, if the
result is to make the financial system significantly less responsive to the more
pressing needs of the rest of the economy.

Getting
exchange rates aligned in the way which needs to happen to spread prosperity
much more evenly across the world would also enable a better balance to be
achieved between the interests of borrowers and lenders. Ultra-low interest
rates are unfair to savers, encourage asset inflation, and lead to
misallocation of resources. The world’s economies would be better served by
interest rates moving to low positive rates net of inflation.

None of these comments
indicate that steps should not be taken to improve regulation and control of
the financial sector where this can be done economically and efficiently. It
does, however, strongly point towards much more effort being put behind world
financial reforms which would make the conditions which precipitate financial
crises much less likely to occur. The time when western economies can be run
with all control of the economy being achieved by fiscal and monetary policies
while the exchange rate, as a policy instrument, is ignored, must surely pass.
Floating exchange rates, left entirely to market forces, are not the answer.
Every country’s exchange rate provides a crucial relationship with every other
country in the world and getting this in the right place is just as important
as the adoption of sensible and realistic fiscal and monetary policies.

This article is part of the There is an Alternative series. An economist and entrepreneur, John Mills is
Chairman of JML. He recently established The Pound Campaign
to raise awareness of the uncompetitive exchange rate and the effect it is
having on UK
manufacturing and the wider economy.

John Mills is a donor to
openDemocracy.

About the author

John Mills is a businessman and economist. He is chairman of direct to consumer retailer, JML, and has published widely as an economist. He sits on the openDemocracy board and is a donor to oD. His most recent book is Exchange Rate Allignments.

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